Why Doesn't The Fed Have Both A Money Supply Target And An Interest Rate Target?

Introduction

The Fed, as the nation's monetary policy authority, influences the availability and cost of money and credit to promote a healthy economy. Congress has given the Fed two coequal goals for monetary policy: first, maximum employment; and, second, stable prices, meaning low, stable inflation. This "dual mandate" implies a third, lesser-known goal of moderate long-term interest rates.

The Fed's interpretations of its maximum employment and stable prices goals have changed over time as the economy has evolved. For example, during the long expansion after the Great Recession of 2007–2009, labor market conditions became very strong and yet did not trigger a significant rise in inflation. Accordingly, the Fed de-emphasized its prior concern about employment possibly exceeding its maximum level, focusing instead only on shortfalls of employment below its maximum level. In this newer interpretation, formalized in the FOMC's August 2020 "Statement on Longer-Run Goals and Monetary Policy Strategy," high employment and low unemployment do not raise concerns for the FOMC as long as they are not accompanied by unwanted increases in inflation or the emergence of other risks that could threaten attainment of the dual mandate goals.

More generally, maximum employment is a broad-based and inclusive goal that is not directly measurable and is affected by changes in the structure and dynamics of the labor market. So, the Fed doesn't specify a fixed goal for employment. Its assessments of the shortfalls of employment from its maximum level rest on a wide range of indicators and are necessarily uncertain. Intuitively, though, when the economy is at maximum employment, anyone who wants a job can get one. And recent estimates of the longer-run rate of unemployment that is consistent with maximum employment are generally around 4 percent.

Fed policymakers judge that a 2 percent inflation rate, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with its mandate for stable prices. The Fed began explicitly stating the 2 percent goal in 2012. In its 2020 "Statement on Longer-Run Goals and Monetary Policy Strategy," the FOMC changed that goal to inflation that averages 2 percent over time, in contrast to aiming for 2 percent at any given time. So, following periods when inflation has persisted below 2 percent, the Fed strives for inflation to be moderately above 2 percent for some time.

Setting Monetary Policy: The Federal Funds Rate

The federal funds rate is the interest rate that financial institutions charge each other for loans in the overnight market for reserves.

The Fed implements monetary policy primarily by influencing the federal funds rate, the interest rate that financial institutions charge each other for loans in the overnight market for reserves. Fed monetary policy actions, described below, affect the level of the federal funds rate. Changes in the federal funds rate tend to cause changes in other short-term interest rates, which ultimately affect the cost of borrowing for businesses and consumers, the total amount of money and credit in the economy, and employment and inflation.

To keep price inflation in check, the Fed can use its monetary policy tools to raise the federal funds rate. Monetary policy in this case is said to "tighten" or become more "contractionary" or "restrictive." To offset or reverse economic downturns and bolster inflation, the Fed can use its monetary policy tools to lower the federal funds rate. Monetary policy is then said to "ease" or become more "expansionary" or "accommodative."

Implementing Monetary Policy: The Fed's Policy Toolkit

The Fed has traditionally used three tools to conduct monetary policy: reserve requirements, the discount rate, and open market operations. In 2008, the Fed added paying interest on reserve balances held at Reserve Banks to its monetary policy toolkit. More recently the Fed also added overnight reverse repurchase agreements to support the level of the federal funds rate.

Reserve Requirements

The Federal Reserve Act of 1913 required all depository institutions to set aside a percentage of their deposits as reserves, to be held either as cash on hand or as account balances at a Reserve Bank. The Act gave the Fed the authority to set that required percentage for all commercial banks, savings banks, savings and loans, credit unions, and U.S. branches and agencies of foreign banks. These institutions typically have an account at the Fed and use their reserve balances to meet reserve requirements and to process financial transactions such as check and electronic payments and currency and coin services.

For most of the Fed's history, monetary policy operated in an environment of "scarce" reserves. Banks and other depository institutions tried to keep their reserves close to the bare minimum needed to meet reserve requirements. Reserves above required levels could be loaned out to customers. So, by moving reserve requirements, the Fed could influence the amount of bank lending. Promoting monetary policy goals through this channel wasn't typical though.

Still, reserve requirements have played a central role in the implementation of monetary policy. When reserves weren't very abundant, there was a relatively stable level of demand for them, which supported the Fed's ability to influence the federal funds rate through open market operations. The demand for reserves came from reserve requirements coupled with reserve scarcity. If a bank was at risk of falling short on reserves, it would borrow reserves overnight from other banks. As mentioned above, the interest rate on these short-term loans is the federal funds rate. Stable demand for reserves allowed the Fed to predictably influence the federal funds rate—the price of reserves—by changing the supply of reserves through open market operations.

During the 2007–2008 financial crisis, the Fed dramatically increased the level of reserves in the banking system when it expanded its balance sheet (covered in more detail below). Since that time, monetary policy has been operating in an "ample" reserves environment, where banks have had many more reserves on hand than were needed to meet their reserve requirements.

In this ample reserves environment, reserve requirements no longer play the same role of contributing to the implementation of monetary policy through open market operations. In 2020, then, the Federal Reserve reduced reserve requirement percentages for all depository institutions to zero.

The Discount Rate

The discount rate is the interest rate a Reserve Bank charges eligible financial institutions to borrow funds on a short-term basis—transactions known as borrowing at the "discount window." The discount rate is set by the Reserve Banks' boards of directors, subject to the Board of Governors' approval. The level of the discount rate is set above the federal funds rate target. As such, the discount window serves as a backup source of funding for depository institutions. The discount window can also become the primary source of funds under unusual circumstances. An example is when normal functioning of financial markets, including borrowing in the federal funds market, is disrupted. In such a case, the Fed serves as the lender of last resort, one of the classic functions of a central bank. This took place during the financial crisis of 2007–2008 (as detailed in the Financial Stability section).

Open Market Operations

Traditionally, the Fed's most frequently used monetary policy tool was open market operations. This consisted of buying and selling U.S. government securities on the open market, with the aim of aligning the federal funds rate with a publicly announced target set by the FOMC. The Federal Reserve Bank of New York conducts the Fed's open market operations through its trading desk.

If the FOMC lowered its target for the federal funds rate, then the trading desk in New York would buy securities on the open market to increase the supply of reserves. The Fed paid for the securities by crediting the reserve accounts of the banks that sold the securities. Because the Fed added to reserve balances, banks had more reserves that they could then convert into loans, putting more money into circulation in the economy. At the same time, the increase in the supply of reserves put downward pressure on the federal funds rate according to the basic principle of supply and demand. In turn, short-term and long-term market interest rates directly or indirectly linked to the federal funds rate also tended to fall. Lower interest rates encourage consumer and business spending, stimulating economic activity and increasing inflationary pressure.

On the other hand, if the FOMC raised its target for the federal funds rate, then the New York trading desk would sell government securities, collecting payments from banks by withdrawing funds from their reserve accounts and reducing the supply of reserves. The decline in reserves put upward pressure on the federal funds rate, again according to the basic principle of supply and demand. An increase in the federal funds rate typically causes other market interest rates to rise, which damps consumer and business spending, slowing economic activity and reducing inflationary pressure.

Interest on Reserves

The interest rate paid on excess reserves acts like a floor beneath the federal funds rate.

As a result of the Fed's efforts to stimulate the economy following the 2007–2008 financial crisis, the supply of reserves in the banking system grew very large. The amount is so large that most banks have many more reserves than they need to meet reserve requirements. In an environment with a superabundance of reserves, traditional open market operations that change the supply of reserves are no longer sufficient for adjusting the level of the federal funds rate. Instead, the target level of the funds rate can be supported by changing the interest rate paid on reserves that banks hold at the Fed.

In October 2008, Congress granted the Fed the authority to pay depository institutions interest on reserve balances held at Reserve Banks. This includes paying interest on required reserves, which is designed to reduce the opportunity cost of holding required reserve balances at a Reserve Bank. The Fed can also pay interest on excess reserves, which are those balances that exceed the level of reserves banks are required to hold. The interest rate paid on excess reserves acts like a floor beneath the federal funds rate because most banks would not be willing to lend out their reserves at rates below what they can earn with the Fed.

Overnight Reverse Repurchase Agreements

The interest rate on reserves is a crucial tool for managing the federal funds rate. However, some financial institutions lend in overnight reserve markets but aren't allowed to earn interest on their reserves, so they are willing to lend at a rate below the interest on reserves rate. This primarily includes government-sponsored enterprises and Federal Home Loan Banks.

To account for such transactions and support the level of the federal funds rate, the Fed also uses financial arrangements called overnight reverse repurchase agreements. In an overnight reverse repurchase agreement, an institution buys securities from the Fed, and then the Fed buys the securities back the next day at a slightly higher price. The institution that bought the securities the day before earns interest through this process. These institutions have little incentive to lend in the federal funds market at rates much below what they can earn by participating in a reverse repurchase agreement with the Fed. By changing the interest rate paid in reverse repurchase agreements, in addition to the rate paid on reserves, the Fed is able to better control the federal funds rate.

In December 2015, when the FOMC began increasing the federal funds rate for the first time after the 2007–2008 financial crisis, the Fed used interest on reserves, as well as overnight reverse repurchase agreements and other supplementary tools. The FOMC has stated that the Fed plans to use the supplementary tools only as they are needed to help control the federal funds rate. Interest on reserves remains the primary tool for influencing the federal funds rate, other market interest rates in turn, and ultimately consumer and business borrowing and spending.

Nontraditional and Crisis Tools

When faced with severe disruptions, the Fed can turn to additional tools to support financial markets and the economy. The recession that followed the 2007–2008 financial crisis was so severe that the Fed used open market operations to lower the federal funds rate to near zero. To provide additional support, the Fed also used tools that were not part of the traditional toolkit to lower borrowing costs for consumers and businesses. One of these tools was purchasing a very large amount of assets such as Treasury securities, federal agency debt, and federal agency mortgage-backed securities. These asset purchases put additional downward pressure on longer-term interest rates, including mortgage rates, and helped the economy recover from the deep recession. In addition, the Fed opened a series of special lending facilities to provide much-needed liquidity to the financial system. The Fed also announced policy plans and strategies to the public, in the form of "forward guidance." All of these efforts were designed to help the economy through a difficult period.

Recently, the Fed responded to the COVID-19 pandemic with its full range of tools, to support the flow of credit to households and businesses. This included both traditional tools and an expanded set of non-traditional tools. The traditional tools included lowering the target range for the federal funds rate to near zero and encouraging borrowing through the discount window, in addition to lowering the discount rate and increasing the length of time available to pay back loans. On the non-traditional side, the Fed purchased a large amount of Treasuries and agency mortgage-backed securities, and opened a set of lending facilities under its emergency lending authority that is even broader than what was established during the crisis a dozen years earlier. These tools are designed to support stability in the financial system and bolster the implementation of monetary policy by keeping credit flowing to households, businesses, nonprofits, and state and local governments.

The Fed's Balance Sheet

A chart of the Fed's balance sheet is available below and provides details on five broad categories of assets, including 1) U.S. Treasury securities; 2) federal agency debt and mortgage-backed securities; 3) conventional lending to financial entities; 4) emergency lending facilities authorized under Section 13(3) of the Federal Reserve Act; and 5) other assets.

As shown in the chart, the Fed's balance sheet has expanded and contracted over time. During the 2007–08 financial crisis and subsequent recession and recovery, total assets increased significantly from approximately $870 billion before the crisis to $4.5 trillion in early 2015. Then, reflecting the FOMC's balance sheet normalization program that took place between October 2017 and August 2019, total assets declined to under $3.8 trillion. Beginning in September 2019, total assets started to increase again, reflecting responses to disruptions in the overnight lending market. The most recent increase, beginning in March 2020, reflects the Fed's efforts to support financial markets and the economy during the COVID-19 pandemic.

Sources:

Factors Affecting Reserve Balances – H.4.1, Federal Reserve Board of Governors, July 9, 2020.

FAQs: Money, Interest Rates, and Monetary Policy, Federal Reserve Board of Governors, March 1, 2017.

Federal Reserve Press Release: Decisions Regarding Monetary Policy Implementation, December 16, 2015.

Federal Reserve Press Release: Federal Reserve Actions to Support the Flow of Credit to Households and Businesses, March 15, 2020.

Federal Reserve Press Release: FOMC statement of longer-run goals and policy strategy, January 25, 2012.

Federal Reserve Press Release: Interest on Reserves, October 6, 2008.

Federal Reserve Press Release: Policy Normalization Principles and Plans, September 17, 2014.

The Federal Reserve System Purposes & Functions, Federal Reserve Board of Governors, Tenth Edition, October 2016.

Federal Reserve's Exit Strategy, testimony by Ben S. Bernanke, Chairman, Federal Reserve Board of Governors, before the Committee on Financial Services, U.S. House of Representatives, Washington, D.C., March 25, 2010.

The Federal Reserve's Policy Actions during the Financial Crisis and Lessons for the Future, speech by Donald L. Kohn, Vice Chairman, Federal Reserve Board of Governors, at the Carleton University, Ottawa, Canada, May 13, 2010.

FedPoints: Federal Funds and Interest on Reserves, Federal Reserve Bank of New York, March 2013.

FedPoints: Open Market Operations, Federal Reserve Bank of New York, August 2007.

Guide to changes in the Statement on Longer-Run Goals and Monetary Policy Strategy, Federal Reserve Board of Governors, August 27, 2020.

Monetary Policy 101: A Primer on the Fed's Changing Approach to Policy Implementation, by Jane E. Ihrig, Ellen E. Meade, and Gretchen C. Weinbach, Federal Reserve Board of Governors, Finance and Economics Discussion Series 2015-047, June 30, 2015.

Reserve Requirements, Federal Reserve Board of Governors, March 20, 2020.

Review of Monetary Policy Strategy, Tools, and Communications—Q&As, Federal Reserve Board of Governors, August 27, 2020.

Statement on Longer-Run Goals and Monetary Policy Strategy, Federal Reserve Board of Governors, August 27, 2020.

Summary of Economic Projections, Federal Reserve Board of Governors, June 10, 2020.